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Measuring disincentives to formal work

Does formal work pay? Synthetic measurements of
taxes and benefits can help identify incentives and disincentives to formal
work

Elevator pitch

Evidence from transition economies shows that
formal work may not pay, particularly for low-wage earners. Synthetic
measurements of work disincentives, such as the formalization tax rate or
the marginal effective tax rate, confirm a significant positive correlation
between these measurements and the probability of informal work. These
measures are especially informative for impacts at lower wage levels, where
informality is highest. Policymakers who want to increase formal work can
use these measurements to determine optimal labor taxation rates for
low-wage earners and reform benefit design.

Key findings

Pros

Synthetic measures of taxes and
benefits show the share of informal income that is lost when
workers are formalized. They help quantify disincentives to
formalization.

The tax wedge depicts certain costs
in income forgone as a result of formal work, such as taxes and
social security contributions.

The marginal effective tax rate is
better than the tax wedge at capturing the relevant costs of
formal work.

The formalization tax rate combines
both the tax wedge and the marginal effective tax rate.

To increase formal work,
policymakers can use synthetic measures to improve taxation at
lower wage levels or reform benefit design.

Cons

Synthetic measures are purely based
on legal obligations and claims for formal work.

Presently, entitlements of
formalization cannot be properly valuated and included in
disincentive measures.

Studies of tax and benefit systems
currently focus on legal obligations and programs only at the
national level.

Country comparisons often present
the tax wedge for average-wage earners. However, accounting for
low-wage earners may be better suited for developing countries
with high rates of informal employment.

Author's main message

Disincentives to accepting a formal job often
outweigh the incentives. Evidence from transition economies shows a
significant positive correlation between measures of disincentives for
formal work and the incidence of being informal. The formalization tax rate
and the marginal effective tax rate are useful measures. The higher these
measures are, the more likely especially low-wage workers will be informal.
The tax wedge is an alternative measure; however it fails to adequately
capture disincentives. To design policies that encourage formalization,
policymakers need measures that help them understand the disincentives
associated with formal work.